A Brief History of Doom

by Richard Vague

  Fannie Mae and Freddie Mac were, catastrophically as it turned out, the largest institutional holders of mortgages in the United States. They held a combined $4.81 trillion in mortgages out of a total of $10.6 trillion U.S. mortgages.53 By 2007, they held $227 billion in nonprime mortgage pools and altogether an approximate $1.6 trillion in low-quality loans, the credit quality of which was turning out to be much worse than forecast.54 A tidal wave of bad credit engulfed them both. They bravely sought to stave off failure but had historically held little capital for that purpose. Their funders became increasingly reluctant to buy their bonds, which then plummeted in value. Starting in 2007, they began reporting huge quarterly losses—$6.1 billion in the fourth quarter of 2007 and $54.3 billion in the third quarter of 2008—which fatally impaired their limited capital. On September 7, the government, seeking to limit the rapidly expanding crisis, stepped in to take over these institutions.55

  Seeing this, lenders to other companies with large holdings of mortgages became increasingly alarmed. The collapse of Fannie and Freddie and the fire-sale price of Bear Stearns brought into question the value of every other investment bank, most notably Lehman Brothers, which was the fourth largest investment bank in the United States. Lehman had gone “all in” on the mortgage business. In an overall mortgage market that was burgeoning in size and laden with compromised credit, the executives at Lehman failed to see the risk and, more than any other firm, were very literally betting their company on the success of that market. In the elation of the times, Lehman had acquired five mortgage loan companies to increase its stake in the industry. Two of these mortgage lenders were specialists in subprime lending, and so Lehman had $76.28 billion in MBSs, much of which was subprime.56

  In 2007, Lehman’s net income reached a titanic $4.2 billion on revenues of only $19.3 billion. It made huge fees on its mortgage transactions. Its market value reached $60 billion.57 The nature of financial institutions is such that if they do not foresee and make proper provision for loan losses, their reported earnings are huge over the short term. That fact has misled many an executive and investor. As the dark clouds of 2007 gathered, Lehman reassured its investors. During that year, even as it began to pare back some areas of its subprime operations, Lehman continued to aggressively underwrite in this sector, with $85 billion more MBSs, which was quadruple its equity. With this, its assets were now thirty-one times higher than its equity in an industry where ten to twenty times is viewed by many as the limit of prudence.58

  In March 2008, after the announcement of Bear Stearns, Lehman’s shares fell more than 40 percent on concerns about its MBS exposure. But investors were blind and gave Lehman new investment support over the next few months. These new investors reasoned that if the company had been worth $60 billion and now was worth only $20 billion, then this was a buying opportunity. And so, in April, Lehman got $4 billion in new preferred stock; in June, though it had reported a $2.8 billion loss, it raised another $6 billion, and decreased its leverage. This was Chicken Little in reverse. The sky was falling, but no one involved had truly noticed.

  In September, even with the new equity, Lehman’s stock dove 77 percent, and, more important, its short-term lenders began to pull its credit lines. At this point the game was over. Though Lehman announced further restructuring as it preannounced another major loss on September 10, it was down to $1 billion in cash, which for an institution of that size and hemorrhaging money would only last weeks. That same day, Moody’s announced another ratings downgrade for Lehman unless a major firm took significant stake in the company. Lehman spent the weekend in discussions with Bank of America and Barclays, trying without success to craft such an investment.

  And so, on Monday, September 15, 2008, with a reported but likely overstated $639 billion in assets along with $619 billion in debt and more than 20,000 employees, and just days after the rescue of Fannie Mae and Freddie Mac, Lehman filed for bankruptcy. It was the largest bankruptcy in history to that point. The decision stunned the market. The government decided against rescuing Lehman as it had Bear Stearns and let it fail. Some cynics argued that Treasury secretary Hank Paulson, who had formerly worked at Goldman Sachs, would not deign to assist a firm that had been a lifelong competitor.

  Some consider the Lehman failure the defining moment in the unraveling of the U.S. economy, but the crisis was inevitable well before that moment. The Lehman failure shattered the market’s faith that the government was going to contain the crisis. If the government was not going to save major institutions, the future was dire. The reverberating fear made the government newly aware of the danger, and so its intervention accelerated to lightspeed.

  On that same day, Bank of America, having already taken on unrecognized risk with its acquisition of Countrywide, announced that it had agreed to buy Merrill Lynch. It was a major and important transaction, although the frenzy drowned it out. Merrill Lynch too had plunged perilously deep into the mortgage market and was facing failure, and Bank of America was unwittingly assuming billions of additional dollars in mortgage-related losses. Bank of America’s acquisitions of Countrywide and Merrill were in part opportunistic and in part a desire to mask the deterioration of its own loan portfolio. The Fed was an eager accomplice because it was increasingly desperate to find homes, any homes, for the growing list of troubled problem institutions.

  The very next day, on September 16, the government stepped in to rescue the insurance giant AIG. AIG had been a major seller of CDSs to investors betting against the mortgage market from 2005 to 2007. If those underlying mortgages were good, which, given their high ratings, AIG executives assumed they would be, then AIG would have made millions in fees. If they went bad, then AIG would have to pay the buyers of those swaps in proportion to the amount of the losses. What was unrecognized at the highest level of AIG management was that it had sold such an extraordinary volume of CDSs that the entire company would go under if they went bad. Unwittingly, and in an activity that was largely unrecognized and unsupervised by its executive management, AIG had bet the company. And they lost the bet.

  The previous day, recognizing this and concerned with rapidly emerging mortgage trends, all three rating agencies had downgraded AIG’s credit rating, which meant, under the terms of the swaps, that it was obligated to post more collateral—in other words, fork over money—to the firms that had bought these swaps. In fact, calls for this collateral rose to $32 billion, and the company’s shortfall quickly totaled $12.4 billion. But AIG simply didn’t have the cash. Goldman Sachs was a key funder of AIG and thus had much to lose if AIG failed. Again, some viewed this government rescue as Secretary Paulson looking out for the best interests of his former employer.

  In the chaotic and contradictory spirit of the times, the Fed’s rescue of AIG came not long after Secretary Paulson had said there would not be any more Wall Street bailouts, not long after the government had rescued Fannie and Freddie, and only six months after the rescue of Bear Stearns. It stepped in with an $85 billion two-year loan and took ownership of 79.9 percent of AIG’s equity, revised in the soon-to-be-enacted Troubled Asset Relief Program (TARP) to a $40 billion purchase of preferred shares and a $52.5 billion purchase of mortgage-backed securities.

  Short-term rates had been 5.25 percent a year earlier. The Fed had knocked them down to 4.25 percent in January, then all the way down to 3 percent in February, and then to 2 percent in April. It now lowered rates to 1 percent.

  The magnitude of these rescues was unprecedented yet extemporized. It was now time for a more comprehensive structure to deal with what was clearly a nationwide, systemic crisis. So days later, Paulson and Bernanke went to Congress to formally ask for $700 billion to rescue the entire U.S. economy. That emergency rescue legislation, enacted in a whirlwind and signed by President Bush on October 3, 2008, was called the Emergency Economic Stabilization Act of 2008, and created TARP, which authorized the government to spend up to $700 billion for stabilization. The government would now invest directly in the stock
of troubled banks and in effect provide a guarantee to the creditors and counterparties of that bank. (On November 25, this was augmented with the Term Asset-Backed Securities Lending Facility, or TALF, to support owners of securities backed by credit card debt, student loans, auto loans, and small-business loans.)59

  Within days of its passage, the Treasury secretary called a meeting of nine leading lending institutions and required them to accept its investment and the associated implicit guarantee. Those institutions were JPMorgan Chase & Company, Citigroup Inc., Goldman Sachs Group Inc., Morgan Stanley, Wells Fargo & Company, State Street Corporation, Bank of New York Mellon, and Bank of America Corporation, including the soon-to-be-acquired Merrill Lynch. Some protested because they objected to the implication that they were near failure. But most were, not just because of their impaired credit but also because of their liquidity risk. Paulson required that they accept the funds because he wanted to restore confidence in the entire market and felt if all these high-profile institutions took the funds, it would make an emphatic statement to the market and encourage others to do the same.

  The Treasury soon had invested in a total of 214 financial institutions. Eventually, $427 billion was disbursed, but over time the government claimed that most or all of that was recovered through the sale of stock and other assets. TARP largely achieved the objective of stabilizing the financial institution markets. It gave banks and other financial institutions the certainty of liquidity and funding, and, with that, it gave them the time to determine the extent of their problems, to raise capital, and to begin the disposition of bad loans in a more orderly manner. The stock market ended its decline only two months later, and employment finally started to rise ten months later.

  But the pain and turbulence were not over. The era had its sideshow of fraud, and the Great Recession’s biggest came to light on December 11 with the arrest of Bernie Madoff. His Ponzi scheme, possibly the biggest financial fraud of all time, had lasted over fifteen years and cost investors tens of billions of dollars.60 It was the stock market crash that unmasked the fraud as his investors scrambled to withdraw funds. As investor Warren Buffett said, only when the tide goes out do you discover who has been swimming naked.61

  On December 16, for the first time in history, the Fed lowered its benchmark interest rate to zero, where it would remain for the next seven years—as evidence of the critically weak economy and the Fed’s desire to give interest rate relief to the private-sector borrowers, who, despite some improvement, had remained highly leveraged.62 The Fed also stepped up its effort to provide liquidity to lenders.

  On December 19, the government intervened to prop up General Motors and Chrysler, offering an initial $13.4 billion loan from the TARP fund, but they remained on the verge of bankruptcy. In the face of considerable criticism and opposition, the Obama administration continued the rescue efforts. Counting the $13.4 billion in loans already made, the government invested a total of $49.5 billion in GM, eventually recovering $39 billion, and $12.5 billion in Chrysler, recovering $11.2 billion.

  The Eurozone was contending with its part of the global meltdown. By November 14, 2008, it had officially slipped into a recession for the first time since its creation in 1999, pushed down by recessions in Germany and Italy. In the United Kingdom, by the fall of 2008, housing prices had dropped 15 percent from the previous year, and over 500,000 mortgage holders found they had negative equity in their houses, “with another 700,000 mortgage holders facing the same risk if prices continue to fall.”63 The United Kingdom officially fell into a recession in the third quarter of 2008, and unemployment took its first big step up to 6.1 percent that fall.64 (Notably, in Britain, mortgage and rent payments could be made for the unemployed under its social security program.)

  Table 6.2. U.K. Crisis Matrix: 2000s

  In the five years leading to 2008, Britain’s private debt grew by 54 percent.

  Mortgage and commercial real estate comprised 51 percent of the increase, but non-CRE business debt was a large category that increased rapidly as well.

  Greece, whose troubles grabbed outsized attention, had its own massive private lending burst, with private debt growing from 54 percent to 118 percent of GDP between 2000 and 2008. Its problematic government debt growth followed that private debt burst. The same was true in Italy. Spain, having been perhaps the most profligate lender of all in this era, suffered the most drastic fall. Spain’s acceleration had begun in 1999, and by the early 2000s, it already had crossed the private debt growth thresholds identified in this book as a harbinger of crisis. But the nation didn’t have its crisis until 2008—largely because it kept lending. There are any number of ways lenders can keep companies afloat long after troubling trends have emerged. For example, a lender can keep a real estate company with poor sales afloat by allowing it to continually renew maturing loans and pay interest only or no interest, and even by increasing the amount of the loan. This has happened repeatedly for any number of companies in the late phases of lending booms. Spain’s continued boom was further abetted by countries around it that were beginning their acceleration of lending. The party is often over only when lenders stop lending and the crisis, deferred, finally arrives. However, by keeping that party going for so long, Spain had only expanded the size and dimension of its eventual problem.

  Table 6.3. Spain Crisis Matrix: 2000s

  In the five years leading to 2007, Spain’s private debt grew by 121 percent, and outgrew GDP by almost 4 to 1.

  Construction spending in Spain plunged, GDP fell by 3.3 percent in 2009, and unemployment began its upward march to a painful 26 percent. Some housing developments began to resemble ghost towns. One airport, the €1.1 billion Ciudad Real Central Airport, stood almost empty. In 2015, a group of international investors bought it for a pittance of €10,000.

  Figure 6.8. Spain: Private and Public Debt as a Percentage of GDP, 2000–2015 In Spain, private debt increased by 1.2 trillion Euros (or 121.5%) from 2002 to 2007.

  Back in the United States, by January 2009, the government had to step in with $100 billion in guarantees and a fresh $20 billion in bailout funds for Bank of America, the hapless buyer of Countrywide Mortgage and Merrill Lynch. Barack Obama was sworn in as president with a Democratic majority in Congress on January 20, 2009, little more than three months after Bush signed the epic TARP legislation. But the economy was still losing 800,000 jobs per month, and unemployment had reached 7.8 percent; so in less than thirty days, the $787 billion American Recovery and Reinvestment Act of 2009 (ARRA) was enacted, a stimulus bill later revised to a total of $831 billion. It included tax cuts and funding for infrastructure, green energy, schools, and health care to save and create jobs. Its effectiveness has been debated ever since. Opponents note the huge increase in the nation’s debt that is in part due to this bill. Its advocates note that U.S. employment rebounded more quickly than that in other countries where similar stimulus was not as quickly or fully employed.

  On February 25, 2009, the Fed and other regulatory agencies announced they would conduct “stress tests,” simulating a potential future crisis, to ascertain if banks now had adequate capital. Though skeptics questioned whether these tests were sufficiently rigorous, when completed, they had the effect of reassuring markets on the soundness of the overall financial system. In March, AIG reported the largest loss in U.S. corporate history, a record $62 billion for the December quarter of 2008.65 The Dow took another tumble. But the events of 2009 turned out to be the beginning of the end. In June 2009, the Great Recession technically ended after eighteen turbulent months, making it the longest downturn in postwar history. The painful effects would linger. On October 2, 2009, the unemployment rate peaked at 10 percent, hitting double digits for the first time in twenty-six years.

  In July 2010, Congress passed the Dodd-Frank bill, designed to minimize the risk of future crises. It passed into law those stress tests for banks, created a Consumer Financial Protection Bureau to protect Americans from abusive lending practice
s, increased liquidity requirements for banks, established some parameters for mortgage lending, and set higher regulatory standards for “systemically important” institutions. Some criticized Dodd-Frank as too much; others criticized it as too little. Home foreclosures hit a painful peak in 2010 at 2.9 million properties and ultimately a reported 9 million Americans lost their homes.66 Over 8 million people lost their jobs. But by March 2011, unemployment was below 9 percent,67 and in August 2013, the Dow hit a new high of 15,658.68 A month later, unemployment fell to 7.2 percent.

  One of the most pervasive, enduring legacies of the Great Recession was underwater mortgages. By late 2009 to early 2010, an estimated 10 million of the country’s 53 million mortgages had a principal balance significantly greater than the market value of the home, largely because home prices had reached a lending-induced peak and then fallen significantly.69 This brought heartache and suffering to these households and led to constrained consumer spending over the ensuing years. On some of these loans, an artificially low ARM rate had adjusted to a higher rate, and these homeowners struggled to make payments. This was one key factor in the Fed’s moves to reduce interest rates. Others found that they could have made these payments if their income had stayed at the boom-era highs, but now they were making less and so were also struggling to make payments. Many families kept up their payments but spent years without taking vacations or buying new cars, and continually resorting to all other types of austerity. This was a key to understanding why the economic growth remained tepid years after the crisis.

  Government debt skyrocketed in the wake of the crisis as tax revenues dropped and government stimulus programs were enacted, and the dramatic increase alarmed many. This is worth noting, because in the crisis fog, some observers conflated rapid growth in government debt, or too much government debt, with the cause of the financial crisis. Even in 2018, after it was abundantly well established that in the 2008 crisis it was not government debt but runaway growth in private debt that brought the fall, many still believed government deficits and debt were part of the problem. But U.S. government debt growth had been benign in the period before the crisis in comparison to private debt growth and was not a part of the cause. Looking across all countries since World War II, most financial crises are not preceded by rapid government debt growth, and most rapid buildups in government debt are not followed by financial crises. In fact, as we have seen, the government debt–to–GDP ratio often improves in years leading to crisis.